Thursday, Sep. 18, 2008

Can China Compete?

To walk through TAL Apparel's new $70 million factory in the blue-collar city of Dongguan is to witness evidence of a sea change in industrial China. Nowhere to be found are the stereotypes of Chinese industry: the buzzing hive of menial laborers, medieval working conditions and outmoded equipment. The factory's pristine white floors and brightly lit aisles look more like a modern office suite than a clothing factory. In one corner, automated cutting machines slice out fabric for men's pants, a process that wastes less material and requires only about half the staff needed to cut patterns by hand. In another section of the plant, a computerized system of ceiling tracks ferries the pants on hangers between sewing stations instead of having workers pass the pieces along. At the end of the assembly line, the high-quality garments emerge sporting brand names like L.L. Bean and Dockers. S.N. Yip, a director at TAL, says that only the most modern, efficient factories can thrive in today's China. "If you want to run a sweatshop," he says, "this isn't the place."

Yip, like thousands of other Chinese factory owners, knows there's no real future in Chinese sweatshops. Sure, China for many years has been the country of choice for multinational companies looking to set up factories, taking advantage of the country's vast pool of dirt-cheap labor and lax environmental and labor laws to produce the toys, clothes, electronics and other consumer goods that flooded retailers shelves worldwide. It's an industrial model that has served China well, providing double-digit economic-growth rates and lifting millions out of poverty. But it is also a model that, inexorably, is starting to break down. Soaring costs for labor and raw materials, along with tougher government oversight and an appreciating national currency, are playing havoc with the profit margins of China's low-cost producers and the country's seemingly unstoppable export machine. Over the past year or so, factories started shutting down in China's Guangdong province, the country's industrial heartland that produces more than 30% of its exports. As many as 20,000 may have already closed. Credit Suisse estimates some 60,000 export-oriented factories — or a full third of those operating in Guangdong — will cease to exist within three years. During the first half of 2008, the city of Shenzhen (which like Dongguan is in Guangdong province) experienced the slowest growth since it was designated one of China's first special economic zones in 1979.

Which raises a question, one that is likely to be brought up when the World Economic Forum meets in Tianjin, China, later this month: In a global economy where factory sites are increasingly stateless and fungible, can China compete? This is not as absurd a question as it may seem. Late last year, the consulting firm Booz & Co. conducted a survey of 66 multinational companies with operations in Shanghai and found that 54% believed China is becoming less competitive with other low-cost countries due to rising labor costs and other unhelpful trends. Almost 20% of survey respondents said they had plans to move operations elsewhere, with their first choices Vietnam and India. "From the cost perspective, China has marginally lost its competitiveness compared to its neighbors," says Edward Leung, chief economist at the Hong Kong Trade Development Council.

Viewed from a long-term perspective, it was inevitable that China eventually would lose its edge. The economies of Asia's other tigers — South Korea, Taiwan and Hong Kong — have all undergone a similar transition. After several decades of rapid growth, business costs rose along with living standards, provoking an exodus of low-cost manufacturers (most of them decamped to China). Now the wheel has turned, and China finds itself at the beginning of a new stage in its economic evolution. And while some of the factors that have reduced its advantages, such as spiking commodities prices, may be transient, a critical mass is likely permanent. For one thing, China's interior provinces have experienced their own economic boomlets. As a result, migrants who once traveled hundreds of miles in search of jobs in China's export factories — located mainly near the eastern seaboard in industrial enclaves like Dongguan — can now find decent work closer to home, creating labor shortages and causing salaries to rise precipitously along the coast. The average monthly pay of China's factory workers increased 66% between 2004 and 2007 to $234, an amount that is well above the wages earned in other Asian countries. Factory workers in Indonesia, for example, take home half as much. Then there's the appreciating Chinese currency. In 2005, China unpegged the yuan from the U.S. dollar and allowed it to more accurately reflect its market value. The yuan has climbed ever since, strengthening by about 10% against the dollar in the past year alone. This increase has made exports from China more expensive while increasing the cost of imported raw materials and components.

There are ways that corporations, economies and countries can cope with such changes. Improving worker productivity is one: by modernizing manufacturing methods, factories can churn out more product using fewer workers, thus preserving profit margins. Profits can also be protected by making and selling higher quality, more expensive goods. Indeed, Asia's tigers to one degree or another have all moved up the commercial food chain to offset higher costs by advancing into sophisticated, value-added products and services such as cars, high-tech gear and financial services.

China is headed in the same direction, and the government is doing a lot of the driving. Stung by criticism that its factories churn out shoddy merchandise and tainted food, officials in Beijing want to improve the quality and reputation of the country's exports. This task is all the more urgent because the Chinese people are growing increasingly angry over the environmental degradation and social inequity that have been byproducts of the country's breakneck growth. Beijing realizes its manufacturing sector needs to adopt higher standards and better spread the benefits of the economic boom to the working class. The bureaucracy's instrument in achieving these goals has been blunt: a slate of reforms aimed at forcing the country's low-end factories to clean up their acts. Tighter pollution regulations are pressing companies to invest in expensive new machinery and improve their waste-management systems. Stringent labor laws, implemented this year, mandate overtime and severance pay, and restrict companies' ability to lay off workers. The laws provide far more protection to employees, but Credit Suisse estimates they add 15-20% to the cost of running a labor-intensive factory. These reforms are putting some cash-starved manufacturers out of business. Better-capitalized companies are investing in advanced technologies and improved product lines. Beijing's officials "are thinking that [regulatory reforms] move people up the value chain," explains Alex Fong, chief executive of the Hong Kong General Chamber of Commerce. "They have looked at history and learned from it, and are trying to apply it to China."

Eddie Leung, founder of Hong Kong watchmaker Dailywin Watch Products, says he thinks Beijing's campaign is having the desired effect. Leung opened his factory in Dongguan in 1989 in search of lower labor costs. Today his 650 workers churn out 200,000 watches a month for brands such as Tommy Hilfiger and Anne Klein. Over the past 12 months, China's new labor laws, higher fuel prices and currency appreciation have increased his costs by about 30%, Leung says. He's responding by adjusting his product mix and improving production methods. Earlier this year, he installed an advanced clean room in his factory — similar to those used in semiconductor plants to keep out dust — for assembling pricier precision watches. He added machines used to clean charms for watch bracelets that are 60% faster than manual labor alone. In all, Leung says greater automation and other changes have boosted his output by 8% even though he has reduced his staff by some 30 workers, and more upgrades are planned. "If it wasn't for the government policy," Leung says, "I might be doing my business the same as two years ago."

Not every factory owner, however, has been able to adjust. Beijing's reforms have kicked in at just the wrong time. A global economic slowdown is curtailing orders for the region's consumer goods. Facing a double whammy of higher costs and slower sales, thousands of low-end Guangdong factories are on the verge of failure. The region is essentially one big industrial park with tens of thousands of factories connected by dusty roads packed with trucks. But closures are starting to leave scars in cities such as Dongguan. A short drive from the Dailywin plant, a former plastics factory stands abandoned, with refuse stacked up in its courtyard. Down the road, a watch factory, though still operating, has vacated two-thirds of its plant. A loudspeaker at the gate endlessly repeats a recorded message seeking a new tenant for the building.

In theory, the result of this painful winnowing process will be a more efficient and competitive manufacturing sector. China is "maintaining the strong and eliminating the weak," says Paul Yin, president of the Chinese Manufacturers' Association of Hong Kong. "The stronger, bigger manufacturers will survive and probably be better." While this transformation is taking place, however, the impact on the Chinese economy might be severe. Factory closures will reduce the number of available jobs for China's 1.3 billion people, which could foment social unrest. Guangdong could even fall into recession over the next two to three years, says Dong Tao, an economist at Credit Suisse in Hong Kong. The danger, he says, is that factories are vacating the region too quickly for new production to take its place. "It is easy to push people out, but harder to create new industries," says Tao. "The pressure is on."

The effects of China's industrial reformation will be felt well beyond the nation's borders. A higher-cost export sector in China will likely mean higher prices for many essential products worldwide. An April survey of Chinese consumer-goods suppliers by Global Sources, a Hong Kong – based sourcing information provider, found that 90% planned to raise prices this year, adding to worldwide inflationary pressures. "We took it for granted that Chinese products would be cheap forever," says Tao. But "the beginning of the end of this period may have already arrived. 'Made in China' won't be sold as cheap as before."

This could cause pain in the Wal-Mart aisles, but it's a boon for countries such as India and Bangladesh, where average wages are low. Economists anticipate that companies making labor-intensive products like clothing will increasingly look beyond China to set up new factories. Credit Suisse's Tao predicts that a third of the factories closing in Guangdong might pop up in other countries. Vietnam, where wages are about 40% lower than in China, has already been a beneficiary. Over the past several years, manufacturers looking to diversify their production bases have been investing heavily in Vietnamese factories. ThreeSixty Sourcing, a Hong Kong – based buying agent for multinational brands, is in the process of opening its first office in Ho Chi Minh City to seek out new suppliers for its customers, away from China's rising costs. "We've historically been very China-focused," says Chris Laurence, ThreeSixty's CEO. But "for the first time there are challenges [in China]. When things are good people don't look elsewhere, but when things aren't good people start looking."

China, though, still retains some major competitive advantages. Businessmen say that clusters of factories in similar industries that have formed along the mainland's coast create a ready supply chain for important raw materials and components, while China's superior infrastructure makes shipping products overseas extremely efficient. These factors have convinced many industrialists to stay put. "I've asked myself: Can I move my operations out of China?" says Clarence Cheung, director of You Eal, a manufacturer of keypads for mobile phones and remote controls. "The answer: It's impossible." Other factory owners have chosen to open plants deeper in China's interior, where they can find lower wages and a larger pool of job seekers, rather than move to other countries. Willy Lin, managing director of Hong Kong sweatermaker Milo's Knitwear, opened a factory earlier this year in Jiangxi province, some 400 miles (650 km) from Hong Kong, where his costs of operation are about 20% lower than in Dongguan. "We all have to deal with the new China," Lin says.

These advantages, however, won't last forever. As Beijing attempts to reform China's manufacturing sector, competitors are striving to catch up. India is rushing to improve its feeble infrastructure; Indonesia is changing its investment and tax laws to make itself more attractive to foreign firms. If these countries can add their lower labor costs to a friendlier business climate, they could begin to give China a run for the world's money. At TAL, managing director Harry Lee is still committed to China — he plans to double the size of his Dongguan factory by next year — but he adds that the changing commercial landscape has made it harder to decide where to build a factory in the future. "Five years ago, my first choice would have been China; my second, China; and my third, China," he says. "Now my first three choices are: I don't know, I don't know and I don't know." For several years, China has been leading the global manufacturing race. The country will have to keep on its toes to stay out in front.

with reporting by Ling Woo Liu / Dongguan and Martha Ann Overland / Hanoi